Monday, November 20, 2006

Property/casualty insurance stocks; The bear case

By "liquidity" design, investors continue to bid up insurance stock prices, reflecting minimal opportunity in the "pure credit area" among financial institution equities. We think the decline in long-term rates (and presumed forthcoming decline in short term rates) has put off the day of reckoning for this latter group, since liabilities are just moved further out on the term structure for credit underwriters. For p/c insurers, the valuation boost from the lower earnings discount rate gets an added kick due to the fact that most insurance portfolio investments are in corporate and treasury paper. This "portfolio manager's" framework masks the underlying deterioration in insurance earnings fundamentals. And while "intellectual capital" in the insurance industry has some value, insurance is still basically a commodity business, with long term returns (ROEs) likely to revert to the marginal cost of capital (if not lower). Who would have ever imagined insurance entities generating returns in the high teens/low twenties ROEs (as reported by ACE and XL)? Given that there are only two major components in the income stream, investors continue to believe that margin erosion will be minimal in the next two years. I would hazard a guess that margins peaked in 2006, and will fall 10 points (minimum on combined ratio) by 2008, and perhaps substantially more by 2009.

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